Betting on Grexit

A capital flight mechanism I hadn't thought of, from  Hans-Werner Sinn (HT Marginal revolution)

Basically, Greek citizens take out loans from local banks, funded largely by the Greek central bank, which acquires funds through the European Central Bank’s emergency liquidity assistance (ELA) scheme. They then transfer the money to other countries to purchase foreign assets (or redeem their debts),... 

 In January and February, Greece’s TARGET debts increased by almost €1 billion ($1.1 billion) per day, owing to capital flight by Greek citizens and foreign investors. At the end of April, those debts amounted to €99 billion. 

I knew Greeks are taking money out of bank deposits, and parking it abroad, and that in the end this money came from the ECB. When a Greek depositor wants his or her money, the Greek bank gets it from the Greek central bank, who gets it from the ECB, which prints it (metaphorically). It had not occurred to me that of course borrowing every cent you can from a Greek bank and parking it abroad is just as smart.

Of course, If Greece leaves the Euro, the Greek central bank goes bust, the ECB loses and Greek borrowers or ex-depositors keep their euros.

Hans-Werner seems to think capital controls are a good idea to stop this run. I think the likely imposition of capital controls is just why people are running in the first place. Similarly, if both Greece and Europe were to credibly say that Greek government default will not mean leaving the euro that would also stop the run.

But news for the day is this interesting run on the borrowing side, not just the depositor side.

On writing well

The WSJ notable and quotable picked a lovely snippet from “On Writing Well” (1976) by William Zinsser, who died May 12 at age 92. 

Clutter is the disease of American writing. We are a society strangling in unnecessary words, circular constructions, pompous frills and meaningless jargon. 

Who can understand the clotted language of everyday American commerce: the memo, the corporate report, the business letter, the notice from the bank explaining its latest “simplified” statement? What member of an insurance plan can decipher the brochure explaining the costs and benefits? What father or mother can put together a child’s toy from the instructions on the box? Our national tendency is to inflate and thereby sound important. The airline pilot who announces that he is presently anticipating experiencing considerable precipitation wouldn’t think of saying it may rain. The sentence is too simple—there must be something wrong with it. 

But the secret of good writing is to strip every sentence to its cleanest components. Every word that serves no function, every long word that could be a short word, every adverb that carries the same meaning that’s already in the verb, every passive construction that leaves the reader unsure who is doing what—these are the thousand and one adulterants that weaken the strength of a sentence. And they usually occur in proportion to education and rank.

Though each sentence is spare,  Zinsser includes some long and concrete lists. Notice how effective that combination is.

From the New York Times Obituary

His advice was straightforward: Write clearly. Guard the message with your life. Avoid jargon and big words. Use active verbs. Make the reader think you enjoyed writing the piece. 

He conveyed that himself with lively turns of phrase: 

“There’s not much to be said about the period except that most writers don’t reach it soon enough,” ... 

“Abraham Lincoln and Winston Churchill rode to glory on the back of the strong declarative sentence,” ..

Zinsser's book was an inspiration to me.  I highly recommend it to economists and PhD students. (My reading list for a PhD writing workshop.)

Measure your time. You may think you're a social scientist, but in fact you're a writer.

Small shoes and headroom

I talked with Kathleen Hays and Michael McKee on Bloomberg Radio last week, and they asked (twice!) a question that comes up often in thinking about Fed policy: shouldn't the Fed raise rates now, so it has some "headroom" to lower them again if another recession should strike?

I could only answer with my standard joke: That's like the theory that you should wear shoes two sizes too small because it feels so good to take them off at the end of the day.

But the question comes up so often, it's worth thinking about a little more seriously. Under what views about the economy does this common idea make any sense?

One way to think about the question: is the effect of interest rates on the economy path-dependent, so that a given level of short-term interest rates has more "stimulative" effect if it comes from a previously high value than if short-term interest rates were zero all along?

The usual answer is no. The model is usually a linear system, in which lowering the rate from a high value has the same effect as raising to the same rate coming from a low value.  In fact, the usual model goes the other way:  If, say, a new recession hits in June 2017 and you want more stimulus then,  having had rates at zero all along is more "stimulative" than having raised them to 3% between now and then, and lowering rates all of a sudden.  In equations, if \(y_t = \sum \theta_j i_{t-j} + \varepsilon_{t} \) with \(\theta_j \ge0 \) then the partial derivative of any \(y_t\) with respect to any \(i_{t-j}\) is the same no matter what the path of interest rates before time \( t-j\), and raising \( i_t \) today lowers future \( y_{t+j} \) given any set of shocks \(\{\varepsilon_t\}\)  You need some sort of nonlinear system where a higher interest rate today \(i_t\)  makes \( y_{t+j}\) more sensitive to some future rate  \(i_{t+k} \).

Another way to think about this question is to think about what sort of state variables the interest rate affects. If the Fed raises rates now, the economy will be in a different state in June 2017. So in what view of things does raising rates now put the economy in state such that the economy can better weather a shock, or, more to the point, a state in which lowering rates back to zero will be more "stimulative" than if rates were zero all along? People usually think that raising rates between now and May 2017 would lower inflation, output and employment over what they would have been otherwise. Then, once rates go to zero again in June 2017, inflation, output, and employment will be lower than if interest rates had been zero all along.

If the economy were to boom on its own, with inflation, output and employment rising, and the Fed were to follow that good news by raising rates, then yes the Fed would have more "headroom." But that's not an argument that the Fed can get the "headroom" by acting now.

In fact, the opposite  story has been told by those who advocate forward guidance and raising the inflation target. They argue that the Fed should keep rates lower and for longer, in order to raise inflation (the "state variable"). Higher inflation then indeed gives the Fed "headroom" to lower real rates by lowering nominal rates in the next recession.

What does it take to turn this around, and to justify the idea that raising rates gives "headroom" to lower them in the future? The main answer I can think of is to turn the conventional stories around. Suppose that raising interest rates raises inflation, as I have speculated before (here). The desired "headroom" is the desire to raise inflation, so that when June 2017 comes around the same nominal rate (0) corresponds to a lower real rate. I doubt many people articulating the policy view want to travel to Fisher-land and reverse the effect of interest rates on inflation.

You still need a second belief: that despite the wrong sign on inflation the conventional theory has the right sign on output: That lowering rates in June 2017 will fight that recession, even as it will lower inflation again. My little model didn't deliver that. Maybe other models do.

Loud disclaimer: I'm not advocating any position here. I'm just thinking out loud about what kind of views, if any, lie behind this common idea that raising rates now gives the Fed some sort of "headroom" to stimulate the economy in the event of a future recession.

This is a good case for real economic models. There is a lot of cause and effect chat surrounding monetary policy and financial policy that is way ahead of (if you're being polite) or outside of (if you're being accurate) any well-understood or even well-articulated economic model. By tying ideas together, perhaps a policy belief ("headroom") can open one's mind to an interesting causal channel (Fisher equation), or perhaps seeing that channel needed can reverse a policy belief.

Tucker and Bagehot at Hoover

I had the pleasure last week of attending the conference on Central Bank Governance And Oversight Reform at Hoover, organized by John Taylor.

Avoiding the usual academic question of what should the Fed do, and the endless media question will-she-or-won't she raise rates, this conference focused on how central banks should make decisions. Particularly in the context of legislation to constrain the Fed coming from Congress, with financial dirigisme and "macro-prudential" policy an increasing temptation, I found these moments of reflection quite useful.

Some of the issues: Should the Fed follow an "instrument rule," like the Taylor rule? Should it have "goal," like an inflation target, but then wide latitude to do what it takes to attain that goal? What structures should implement such a rule? Implicit in a rule that the Fed should do things, like target inflation and employment, is an implicit rule that it should ignore others, like asset prices, exchange rates and so on. (I think this is much too often overlooked. As financial reform should start by delineating what is not systemic, and hence exempt from regulation, monetary policy rules should start by saying what the Fed should ignore.) Should that limitation be more explicit? What's the right governance structure? Should we keep the regional Feds? How should Fed meetings be conducted? Is "transparency" the enemy of productive debate? How much discretion can an agency have while remaining independent?  And so on.

I was going to post thoughts on he whole conference, but John Taylor just posted an excellent summary, so I'll just point you there.

My job was to discuss Paul Tucker's (ex Deputy Governor of the Bank of England) thoughtful paper, "How Can Central Banks Deliver Credible Commitment and be “Emergency Institutions" Paul's paper starts to think deeply about independent regulatory agencies in general, and monetary and fiscal policy together. My discussion is narrower. I'll pass on the discussion (pdf here) as today's blog post, as it might be interesting to blog readers.

Comments on “How Can Central Banks Deliver Credible Commitment and be “Emergency Institutions” By Paul Tucker

May 21 2015

Let me start by summarizing, and cheering, Paul’s important points.

The standard view says that perhaps monetary policy should follow a rule, but financial-crisis firefighting needs discretion; a big mop to clean up big messes; flexibility to “do what it takes”; “emergency” powers to fight emergencies.

I think Paul is telling us, politely, that this is rubbish. Crisis-response and lender-of-last-resort actions need rules, or “regimes,” even more than monetary policy actions need rules. At a basic level any decision is a mapping from states of the world to actions. “Discretion” just means not talking about it.

More deeply, you need rules to constrain this mapping, to pre-commit yourself ex-ante against actions that you will choose ex-post, and regret. Monetary policy rules guard against “just this once” inflations. Lender of last resort rules guard against “just this once” bailouts and loans.

But you need rules even more, when the system responds to its expectations of your actions. And preventing crises is all about controlling this moral hazard.

To stop runs, our governments guarantee deposits and other loans; they bail out institutions and their creditors; they buy up assets to raise prices, and they lend like crazy. But knowing this, financial institutions take more risk than they would otherwise take, and investors lend without monitoring, making crises worse. Institutions that can borrow at last resort don’t set up backup lines of credit, don’t watch the quality of their collateral, and don’t buy expensive put options and other insurance, making crises worse. Investors who know that the Fed will stop “fire sales,” don’t keep some cash around for “buying opportunities,” making fire sales worse. “Big banks are too complex to go through bankruptcy,” the mantra repeats. But why do people lend to them, without the protections of bankruptcy? Because they know creditors, if not management and equity, will be protected.

“The world is ending. A crisis is no time to worry about moral hazard,” bankers and government officials told us last time, and will tell us again. But the world does not end, and actions taken in this crisis are exactly the cause of moral hazard for the next one.

This isn’t theory. When the Fed and Treasury bailed out Bear Stearns, and especially its creditors, markets learned “Oh, Fed and Treasury won’t let an investment bank broker-dealer go under.” Lehman turned down capital offers, and Reserve Fund losses on Lehman paper were enough to cause it to fail in a run. (This is an update: see below.)

The severe crisis and recession coincident with Lehman’s failure, together with the massive and improvised response — many flavors of Tarp, auto company bailouts, and so on — have arguably created the “rule” in participants’ minds about what will happen next time.

Plans, self-imposed rules, promises, guidance, and tradition are not enough. Given the power, every one of us will bail out. We won’t risk being the captain of the Titanic, and we’ll let the next guy or gal deal with moral hazard. A central banker facing a crisis is like a father holding an ice cream cone, facing a hungry three-year old. Sure, Mom’s rule says dinner always before dessert. We know what’s happening to that ice cream cone.

The central bank and Treasury must not be able to bail out what they should not bail out, to lend where they should not lend, to protect creditors who should lose money. That’s the only way to stop it. More importantly, it’s the only way to persuade the moral hazarders that all the fine words in the boom will not melt quickly in the emergency.

Two central quotes summarize the Tucker view, and I entirely agree.

Prerequisites for any such regime are that its terms should mitigate the inherent problems of adverse selection and moral hazard; be time-consistent; and provide clarity about the amount and nature of ‘fiscal risk’ that the central bank is permitted to take on the state’s behalf.

At a schematic level, a money-credit constitution for today might have five components: inflation targeting plus a reserves requirement that increased with a bank’s leverage plus a liquidity-reinsurance regime plus a resolution regime for bankrupt banks plus constraints on how the central bank is free to pursue its mandate.

***

Now, let me offer a gentle critique.

How are we doing towards the Tucker regime? Not well.

The Dodd-Frank and Basel “regime” has no serious limits at all. Ask yourself, what institutions are not “systemic” and cannot become so designated? What institutions or creditors won’t be bailed out; can’t be bailed out? What are the securities the Fed or Treasury won’t and can’t  buy or lend against? What are the asset prices prices that they won’t and can’t prop up?

Paul points out the difficulties. Yes, “constraints” are good. But just what constraints? We can channel Bagehot, “against good collateral,” to “illiquid but not insolvent” institutions. Except, as Paul reminds us, what’s good collateral, when noone will take anything but Treasuries? How do you tell illiquid from insolvent when prices have tanked and markets are frozen? It’s not so easy.

More deeply, the Bagehot rules are flawed. If it were clear who is illiquid and who is insolvent, there wouldn’t be a crisis. Private lenders would happily support the clearly solvent. And runs happen at institutions that investors fear are insolvent. If you want to stop runs you have to prop up at least the creditors of potentially insolvent institutions. Bagehot’s rules may constrain the central bank; they may be good rules for a prudent investor, they may address moral hazard. But they are not obviously optimal rules to stop crisis or to prevent them from occurring in the first place.

Worse, when we figure all this out, how do we write binding laws or regulations that will effectively constrain bailout-hungry officials?  For example, Paul Volcker proposed a fine clear rule, “thou shalt not finance proprietary trading with deposits.” Which, 600 pages and counting later, is utter mush.

So here we are, 6 years after our crisis — or 82 years after 1932, or 113 years after 1907, or, heck, 300 years after 1720— and as eminent a thinker and practitioner as Paul still needs to invite future thought on what these rules ought to be, let alone just what legal restrictions will actually enforce them and communicate that expectation.

I fear that the next crisis will be upon us long before Paul has figured it out, and a century before he gets the Basel committee, the Fed, ECB, FSOC, Congress, Parliament, SEC, and so on to go along.

***

So, I agree with pretty much all Paul has to say. but I infer the opposite message. If this is what it takes to rescue the house of cards, then we need a different house, one not made of cards. We need to stop crises from happening in the first place.

To its credit, that is the other half of our contemporary policy response: This time, finally, the army of regulators and stress testers will see the crisis coming; with their Talmudic rules and interpretations, and their great discretion, they will stop any “systemically important” financial institution from losing money, despite the moral hazard sirens, and without turning that financial system into something resembling the Italian state telephone company circa 1965.  Good luck with that.

Consider an alternative: Suppose banks had to fund risky lending by issuing equity and long-term debt. Suppose mortgage-backed securities were funded by long-only, floating NAV mutual funds, not overnight repo. Suppose all fixed-value demandable assets had to be backed 100% by our abundant supply of short-term Treasuries. Then we really would not have runs in the first place. And a lot of unemployed regulators.

Why do we not have such a world? Originally, because you can’t do it with the financial, computational, and communications technology of the 1930s or 1960s.  But now we can. More recently, I think, because moral hazard so subsidizes the current fragile system. But now we can change that.

Paul mentioned this possibility, but gave up quickly, conditioning his remarks on a view that society has decided it wants fractional reserve banking. Well, maybe society needs to rethink that decision.

Really, just why is it so vital to save a financial system soaked in run-prone overnight debt? Even if borrowers might have to pay 50 basis points more (which I doubt), is that worth a continual series of crises, 10% or more downsteps in GDP, 10 million losing their jobs in the US alone, a  40% rise in debt to GDP, and the strangling cost of our financial regulations?

***

A last point. Paul unites financial with monetary and fiscal policy. That’s crucial. The last crisis raised US national debt from 60% to over 100% of GDP. The next one will require more. At some point we can’t borrow that much.

But take this thought one step further. The next crisis could well be a sovereign debt crisis, not a repetition of a real estate-induced run. Crises are by definition somewhat unexpected, and come from unexpected sources.

To be concrete, suppose Chinese financial markets blow up, surprise, surprise discovering a lot of insolvent debt. The stress is too much for the IMF and Europe, so Greece goes, followed by Italy Spain and Portugal, half of Latin America and a few American States. Pair that with war in the middle east — Isis explodes a dirty bomb, say — requiring several trillion dollars.

Now Governments are the ones in trouble. They won’t be able to borrow trillions more, bail out banks or lend of last resort.   In a global sovereign debt crisis, even Paul’s regime would turn out to be a superb Maginot line. The current regime wouldn’t be that strong.

A financial system deeply dependent on the government put would be finished.  This is the lesson of Europe. A southern government default would have little consequences if its banks were not so embroiled in government finances.

But a financial system uncoupled from government finances would survive.

***

In sum, I cheer pretty much everything Paul said. But It’s an outline for a plan that will take decades to fill in. And all in the service of keeping the house of overnight debt cards going.

So the lesson I take is that instead, we should finally take seriously the other centuries - old, simple alternative: equity-funded banking, government-provided interest-paying money, mirroring that great 19th century innovation, government-provided banknotes, and a purge of run-prone assets.

 ***

PS:

• Thomas Humphrey writes an interesting  history of Bagehot's rules in the Richmond Fed Review, Averting Financial Crises: Advice from Classical Economists. 
• Renee Haltom has an excellent short article in the same issue, Last-Resort Lending for the 21st Century summarizing current views.
• A spate of news articles came out last summer suggesting Lehman might have been "solvent" after all, here, here, here. Of course "solvent" at ex-post prices selects on one state of the world. Same comment for how much money the government and Fed made on bailout deals. 
• One interesting point came up at the conference (I forget who said this). If the central bank lends against "good collateral," that takes away important assets that rightfully belong to debt-holders, and makes them more likely to run.   

** Update: I originally wrote incorrectly that the Reserve Fund had 40% of its assets in Lehman. A correspondent corrected me and pointed me to McCabe, Holscher, Cipriani, and Martin's BPEA paper whose footnote 27 states

The Primary Fund’s losses were caused largely by its $785 million in holdings of Lehman debt obligations (1.3 percent of the fund’s assets) at the time of Lehman’s bankruptcy. RCMI, the adviser to the fund, announced at about 4 pm on Tuesday, September 16, 2008, that the NAV of the fund’s shares had dropped by 3 percent, to 97 cents, presumably because large redemptions had further eroded the NAV. 

The correspondent adds that money funds can’t have that much  exposure to one counter-party because of limits in rule 2a-7.  1.3 / 3 is about 40%, which must be the number Im remembering -- 40% of the losses, not the assets, came from Lehman. This is even more interesting, because it suggests a run on the fund, rather than large actual losses, was the central problem.  Moral, check your numbers, even ones you think you remember really well.  

Bailout barometer

The Richmond Fed updated its "bailout barometer," at left. Post here and longer report here. (WSJ coverage here)

I found the numbers and the table from the longer report interesting as well. Guaranteeing more than half of financial sector liabilities is impressive. But most of us don't know how large financial sector liabilities are. GDP is about $17 Trillion. $43 Trillion is a lot.

This is only financial system guarantees. It doesn't include, for example, the federal debt. It doesn't include student loans, small business loan guarantees, direct loan guarantees to businesses, the ex-im bank and so on and so forth. It doesn't include non-financial but likely bailouts like auto companies, states and local governments, their pensions, and so on.

Guaranteeing debt subsidizes things off budget. Of course, the chance that the government will have to simultaneously pay all these claims at once in full is small. But the chance that substantial debt guarantees might have to be paid is no longer vanishing.

Homo economicus or homo paleas?

Or at least that's how Google translate renders "straw man."

Dick Thaler is in the news, with a long review of his book in the Wall Street Journal  and a thoughtful opinion piece in the New York Times, earning plaudits from Greg Mankiw no less.

The pieces are nice reference points to think about just where psychological economics is. (That's a better adjective than "behavioral" since we are all students of behavior.)

Bottom line: People do a lot of nutty things. But when you raise the price of tomatoes, they buy fewer tomatoes, just as if utility maximizers had walked into the grocery store.

Homo paleas

Dick spends the first half of his precious space in the New York Times and much of the WSJ review complaining about homo economicus, the dispassionate rational maximizer of economic theory.

Economists discount any factors that would not influence the thinking of a rational person

Econs do not have passions; they are cold-blooded optimizers

This is a straw man, and we all know it. As the joke goes, physics studies massless elephants on frictionless sandpaper. All sciences and engineering make simplifying assumptions appropriate to the problem at hand. If you want to figure out the effect of prices on tomato demand, the absurdly simplified rational maximizer approach gives a darn good answer. If you want to figure out where to put the signs advertising a tomato sale, or what color to draw them, let me suggest some psychology.

To jump from the fact that economists often study simplified models focusing on "rational" decision making, to say that economists uniformly deny that any other principle is useful for understanding any human behavior is absurd. And where in rational maximizing does it state that rational maximizers have no feelings about what they're doing? The experience of rational maximization carries immense feeling.

And even if we are all wrong, that doesn't make Thaler right.

One could just as easily make fun of psychologists and sociologists for ignoring the rationality of much human decision-making, and price incentives in particular. Gary Becker made a splendid career out of that fact.  We could easily write parallel opeds saying all of psychlogy is wrong because they omit the fact that sometimes people do in fact add two and two to get four. But "rationalists" respect logic and their reader's intelligence too much to do that: Psychologists' omissions and simplifications likewise do not invalidate their observations about other aspects of behavior.

Stories vs. achievements

Dick tells good stories. Of 20 paragraphs in the New York Times piece, Dick spends 6 on how his students were happier by rebasing exams to 137 points. Just happier, there is no actual behavior here other than a reduction in "grumbling." Then 5 more paragraphs of stories, like why do non-economist spouses want presents on anniversaries.

Only on paragraph 16 do we get a real observation about real behavior: Employers have found that people tend to take the default retirement plan, so if that default plan includes more saving, people are likely to save more. And that this incentive works better than some complex tax deduction that even economics professors often can't figure out. One might complain that it shouldn't take a PhD in psychology to figure this out, but peace, it's a good observation.

Paragraph 19 has a second real-world observation: The Obama administration chose to send taxpayers a $100 per month extra rather than a lump sum $1200, in an effort to nudge the taxpayers to spend it rather than pay down debt.  This one is also concrete, but he doesn't give us any evidence that it actually worked as claimed.  More deeply, is psychological economics about changing taxpayers' behavior or about selling programs to government officials?

Most of the Wall Street Journal review passes along Thaler's of complaining about how people resisted his early ideas. Really, now, complaining about being ignored and mistreated is a bit unseemly for a Distinguished Service professor with a multiple-group low-teaching appointment at the very University of Chicago he derides, partner in an  asset management company running $3 billion dollars, recipient of numerous awards including AEA vice president,  and so on.

Note that the inflammatory quotes:  “pure heresy” "blood boiling” "Chicago School’s libertarian beliefs" are his. "This was `treacherous, inflammatory territory,' he writes." He writes.  An objective history of behavioral finance this is not. And news flash, we ask sharp questions at Fama's seminars too.

The nudge for saving experience is good and solid. But the skeptical reader, who does not sing in the choir,  wonders: you've been at it three decades, and this is all you've got?

Decisions

Actually, no, and it's a shame Dick spent all this bandwidth on straw men, stories, and whining about his early reception. Psychological insights are quite useful for helping people to make more rational decisions.

This may surprise some blog readers, but I'm actually quite a "behavioralist," in my hobby life as a competition soaring pilot. We read a lot of sports psychology, and it makes a big difference. When pilots are low over inhospitable terrain in a glider, we are prey to all sorts of unhelpful emotions. "Darn why can't I fly anymore" is common; self-pity combined with ego defense. We train by visualizing a healthy set of emotions, a mental patter, as well as the actual series of decisions that must be made quickly. Better racing performance and better safety demonstrably result.

Psychology has a lot to say about how people make quick decisions in environments of information overload and scarce time.  Traditional economics is not really at fault for assuming "rationality" whatever that may mean. Traditional economics ignores information gathering and processing costs, because they are usually second-order.  Homo economicus got devoured by a lion while working out the dynamic program of how fast to run away.

Behavioral marketing, for example, is a cornerstone of the business school curriculum. I presume Dick's class "Managerial decision making" (syllabus sadly not available) covers a lot of how to use psychology to become more rational. Behavioral finance is excellent marketing for active investment strategies, that's for sure.

Cuteonomics?

When it gets to economics, though -- market outcomes, not individual decisions --  a common complaint is that "behavioral" approaches study small-potatoes effects. OK, some asset might have a price 10 basis points off. OK, Dick knows how to rebase exams to get a bit better teaching ratings. OK, so your non-economist spouse wants roses on Valentine's day. But really, in the big picture of growth, unemployment, inequality, climate -- you name it -- has this risen past cuteonomics? How do I use psychology to study the practical problems of everyday economics, say How much does progressive taxation hinder innovation and growth; How do I separate the risk premium from expected inflation in reading long-term bonds; How much carbon would a tax reduce, and so on?

That's an interesting debate. We could have it. We should have it. There are good points on both sides. Too bad Dick chose not to address it at all.

That is why “economic models make a lot of bad predictions”: some small and trivial, some monumental and devastating.  

says the Wall Street Journal. Too bad it does not list a single "monumental and devastating" prediction, made wrong by conventional economics, and convincingly made by psychological economics. I underline prediction: explanations after the fact ("there was a 'bubble' which you guys can't explain) which could go either way don't count.

Libertarian Paternalism

You know why the Times loves this stuff.

One article directly attacked the “core principle underlying the Chicago School’s libertarian beliefs,” namely consumer sovereignty: “the notion that people make good choices, and certainly better choices than anyone else could make for them.” By empirically demonstrating that consumers often do precisely the opposite, because rationality and self-control are bounded by human perceptual distortions, their paper undercut this principle. This was “treacherous, inflammatory territory,”

The first is flatly untrue. The case for the free market is not that each individual's choices are perfect. The case for the free market is long and sorry experience that government bureuacracies are pretty awful at making choices for people. "Empirically demonstrating" that some people do silly things does not empirically demonstrate that other people, organized into the US regulatory agencies, can make better choices for them. This is another simple failure of basic logic.

And psychological, social-psychological, sociological, anthropological, and sociological study of bureaucracies and regulatory agencies, trying to understand their manifest "irrationality," rather than just bemoan it as libertarians tend to do, ought to be a tremendously interesting inquiry. Where is behavioral public choice? (More in a previous post.)

(And accusing your colleagues of "beliefs" and viewing a paper as "treacherous" is ungracious at least. The Chicago school's prime belief, if there is one, is to let data speak, and hire quality and impact no matter what the answers. That's why that very Chicago school hired him.  Attacking motivations of those who disagree with you is not particularly scientific or "rational," though it is common behavior, especially at the Times. )

The hard nut: Government bureaucracies are staffed by the same homo psychologicus that makes bad private decisions. Except that social psychology is full of lessons ("groupthink" for example) on just how people, organized into committees, not subject to the discipline of competition, make truly awful decisions. And if you want stories of awful bureaucratic decisions, just open the pages of the Wall Street Journal, or the Cato or Hoover webpages.

Let's go back to that great success, the Obama administration's choice to send taxpayers a $100 per month extra rather than a lump sum $1200, in an effort to nudge the taxpayers to spend it rather than pay down debt.  Hmm, is getting the average consumer to go down to Walmart and buy a bunch of stuff they don't need, rather than pay down some debt, put off foreclosure or car reposession, such a great idea? Didn't the last paragraph just tell us how effective enrollment defaults are at getting people to increase savings? Along with a host of other Federal incentives like IRAs and 401(k)s? Just how infinitely rational is all this nudging?

There is a little offering here:

No matter how often they added that bureaucrats are Humans, with their own biases, their critics wouldn’t listen, even when Mr. Sunstein kept repeating that they were not pro-paternalism but rather “anti-anti-paternalism.”

This critic has been listening a lot, and not hearing or seeing any serious psychological study of the perfect rationality of government bureaucracies.

The central problem with Libertarian Paternalism as an alternative to Homo Economicus, is ubi est pater? Where is this hyper-rational Pater who will guide things for us better than the admittedly shoddy job we often do for our selves, and the somewhat less shoddy job that private institutions designed to help us make decisions can do?

The WSJ article takes up the issue

“Could we use behavioral economics to make the world a better place? And could we do so without confirming the deeply held suspicions of our biggest critics: that we were closet socialists, if not communists, who wanted to replace markets with bureaucrats?” Yes, he argues, and yes. Because people make predictable errors, we can create policies and rules that lower the error rate, whether it has to do with reducing driving accidents, getting men who use public urinals to aim better or enticing people to save for retirement—and do it in a way that makes people themselves happier with the results.

"We." Well, at least it is better than the usual passive, "people can be made better off." But just who is this "we, " and how did that "we" avoid all the chaos coming from federal bureaucracies trying to regulate behavior?

The problem, Mr. Thaler argues, is that although economists “hold a virtual monopoly” on giving policy advice, ...

Ah, the benevolent bureaucrat is just getting bad advice. This isn't socialism or communism. It is aristocratism; us the bien-pensant experts, immune from behaviorism and over emotional decision-making (a trait not terribly on display in these articles) can guide the benighted masses, if only the government would listen to us.

Always just over the hill

One would think that after 30 years, one would be looking back at a long string of solid successes. But despite 30 years of trying, both pieces keep promising a golden future, just over the next hill.

By injecting economics with “good psychology and other social sciences” and by including real people in economic theory, economists will improve predictions of human behavior,

Any day now. Well, keep trying. And I'll keep listening. I hope 30 years from now there is a string of solid successes to report, and less  straw men, antagonist-vilification, and funny classroom stories.

Feldstein on inflation

Martin Feldstein has an interesting Op-Ed in the Wall Street Journal, "Why the U.S. Underestimates Growth."

The basic idea is that inflation may be overstated, because it doesn't do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn't talk about monetary policy, but that's interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?


That would mean we are a lot closer to "normal" of course.

It would mean that we really have 0% nominal interest rates, 1.5% deflation rather than 1.5% inflation; +1.5% real rates rather than -1.5% real rates. That is about the ideal monetary policy. Flat nominal wages, so we don't have wage stickiness problems, slight deflation matching productivity increases and a positive but low real rate of interest. We live the Friedman optimal quantity of money. In addition, it means no inflationary distortions and fewer intertemporal distortions in the tax code -- no taxing interest.

The labor market is pretty much back to normal except for the labor force participation rate. The main sign of weakness is real output growth, and Marty suggests that might not even be there.

How should the Fed react? News that real output growth is stronger than the Fed thinks would be an argument to raise rates. News that inflation is weaker than the Fed thinks is an argument to lower rates. At conventional Taylor-rule parameters of 1.5 times inflation plus 0.5 times output gap, news that inflation is 1% lower and output is 1% higher means the lowering effect wins. So, in fact this is an argument to keep rates where they are and to continue basking in the Friedman optimal quantity of money for a while.

In fact, this strikes me as the main conclusion. As Marty points out, if real growth is stronger than we think, that doesn't mean it couldn't be stronger still. If real wages are really rising, that doesn't mean they couldn't be rising more. Weak labor force participation and total factor productivity are not much influenced by inflation measures.

McAndrews on negative nominal rates

Jamie McAndrews of the New York Fed has a thoughtful and clear speech on negative nominal rates and the benefits of currency. (Some previous posts on the subject here  here and here.)

A few high points:

1. Needed: anonymous electronic transactions.

Many (not all) negative interest rate proposals call for the elimination of currency. Currency is dying anyway due to the great advantages of electronic transactions. I bemoaned the loss of privacy and political freedom when the NSA, the IRS, and pretty soon Twitter and the Chinese Department of Hacking have a record of everything you've ever bought or sold. Jamie brings up another important point:

The anonymity afforded by currency transactions prevents a buyer from suffering from any actions taken after the transactions that could exploit the knowledge gained by the seller of the buyer’s identity. For example, identity theft, or theft of credit or debit card information, is avoided through the use of currency. This is an economic benefit that is distinct from valuing privacy from a civil liberties point of view. If currency cannot be used in transactions, buyers are at a disadvantage, and many otherwise beneficial transactions (not related to buyers seeking to engage in tax evasion or otherwise illicit activity) would not take place.

Anonymity has value in many transactions. Anonymity equals finality.

It's not hard to have anonymous electronic transactions. Stored value cards could work well as electronic cash. If regulators allowed it, it would be simple enough to set up a money market fund that allows anonymous investing. Regulators don't allow it.

2. Hysterisis of institutions and the lesson of the 70s


There are fixed costs in setting up many institutions that adapt to negative nominal rates. For example, the option to hold currency:

.. Often, the costs of holding currency securely, by having a safety deposit box or a vault, are fixed costs. Once one has a vault, or has rented a safety deposit box, the costs of storing additional currency in it, up to its capacity, is nil. This suggests that there is a dynamic element to the economics of avoiding negative interest rates: the longer the negative rates are expected to persist, and the lower they are, the more favorable are the returns to investing in a vault. Once the vault investment has been made, maintaining negative rates would likely become more difficult.

An even more far-reaching change that many have suggested would be the creation of a new institution to handle and store currency on behalf of others; this could dramatically reduce the costs of holding currency...

Jamie adds to the clever ways to synthesize zero rate investments, and a cost I hadn't thought of

For example, suppose that one holds a credit card under existing U.S. rules: one can withdraw funds from an account that is earning a negative rate, and pay one’s debt to the credit card company in advance of when it is due, earning a zero return during the prepayment period....

... if one were to receive a check from the U.S. government for a tax refund, one could simply put it in a safe place and earn zero interest on it during the time the check remained undeposited...

...leaving the check undeposited, much like the hoarding of currency, is a negative outcome for society. ... This may impose unexpected costs on the check writer, triggering unplanned overdrafts and associated charges...

...having talented individuals looking for these opportunities is a dead-weight loss to society. We would rather have them use their talents for more socially productive purposes.

We went through this once before. In the 1970s, pricing and financial institutions were set up with small positive interest rates in mind. It took a period of prolonged inflation to induce people to spend all the fixed costs to adapt to high interest rates, including widespread indexation, money market funds, interest-paying checking accounts, and so forth. In turn, the easing of these "frictions," quickly removed the hoped-for benefits of inflation. For example, prices and wages were sticky when there was less inflation. Turn on inflation, and once people put the effort in to index contracts, price and wage stickiness fade, and inflation has much less output and employment effect.

So, the same sorts of legal and financial investments that allowed an economy to adapt to high nominal interest rates can also allow it to adapt to negative interest rates -- at large cost, in time and effort, in rewriting contracts, and in foregoing many advantages of currency. But are we sure the benefits will not disappear at the same time?

3. Financial institutions and negative rates

The health of banks and many other financial institutions depends on earning a spread between what the institutions earn on their assets and what they pay on their liabilities. Negative rates can squeeze bank profits.

and a lot of non-banks too. There is a plausible channel here that negative nominal rates hurt a large swath of financial institutions -- at least until they rewrite all their contracts and persuade all their clients to accept negative rates. This is a channel by which lowering rates could hurt economic activity.

By the way, I learned that those negative rates aren't so negative,

..the central banks that have negative policy rates offer zero rates on many of their deposits from banks, imposing negative rates on the “marginal” deposits. In this way, commercial banks can, in general, charge their retail depositors deposit rates of zero and earn zero at the central bank on at least a large portion of their reserve holdings.

4. Speaking of cause and effect signs...

..people could infer [from a negative interest rate] that the central bank itself has low expectations for inflation and is lowering nominal rates into negative territory as a way to “ratify” the low expected inflation environment. Such an inference would complicate the central bank’s effort to achieve its objective because it could encourage and entrench the public’s expectations for deflation. That could complicate the potential exit from the negative rate regime

Maybe with abundant excess reserves, the Fisher equation is stable -- and that lowering nominal rates will cause inflation to decline. Jamie isn't quite ready to burn at the heretic's stake on this issue, but you can see him edging closer to the fire.